The Oarsman Outlook: October 2019

Summer saw modest advances by major investment categories, adding to already substantial year-to-date gains. Large-company U.S. stocks gained around 2%, though small-caps declined by a similar amount. Many overseas markets posted modestly positive results in local currency terms, though an appreciating dollar curtailed or erased gains for U.S. investors. Most real-estate investments gained, though timber-related holdings fell. Gold rose 4%, while industrial commodities were weaker; crude oil dipped 7%. Bond yields continued to fall (the 10-year U.S. Treasury ended at 1.68%, down from 2.00%, on June 30); steady to improving credit spreads allowed nearly all fixed-income investments to post solid three-month results. 

Within the large-cap U.S. stock universe, better performance came from companies in the Communication Services, Consumer Staples, Technology and Utilities sectors. Relatively weaker returns were found among Basic Materials, Energy, Financial Services and Health Care names. In a notable reversal, value-oriented stocks unambiguously outperformed growth for the first time since the fourth quarter of 2016.

Review

The July-September period saw a continuation of economic and financial-market trends that emerged during the spring: disappointing economic news, broadening central-bank accommodation, falling long-term bond yields, shrinking expectations for corporate profits, and a volatile political backdrop. Major stock indices were narrowly range-bound, with the S&P 500 Index never trading more than approximately 3% above or below its June 30^th level. The decline in bond yields brought the cumulative drop in the 10-year Treasury rate to 156 basis points since November 2018. The U.S. currency appreciated by more than 3%, taking it to its strongest level since early 2017.

Recent readings on the U.S. economy indicated the decade-long expansion was intact but slowing. Second-quarter gross domestic product (GDP) growth was a respectable 2.0%, but below the prior-quarter's 3.1%. Monthly job gains averaged more than 170,000 - keeping unemployment at a multi-decade low (3.7%) - though each report came in weaker than the last; wage growth remained healthy (above 3%). Falling mortgage rates boosted real estate: building permits and housing starts both jumped, while the National Association of Homebuilders' index moved steadily higher; price gains, however, continued to moderate (the most recent year-over-year reading was just +2.1%). The purchasing managers index (PMI) for service firms remained comfortably in the expansion zone. Conversely, its counterpart for the much smaller manufacturing sector signaled contraction for the first time since 2016 (in August) before falling to the lowest level since mid-2009 (in September). Consumer-related data also caused concern, as both survey measures of confidence and 'hard' spending data slipped late in the quarter.

Overseas economic news was broadly disappointing. Eurozone second-quarter GDP growth was just 1.2% (down from 2.0% a year ago), the manufacturing PMI fell to its lowest level since 2012, and the manufacturing-heavy German economy - the region's largest - teetered on the brink of recession. In Japan, second-quarter GDP growth matched the prior reading at 1.0%, but August industrial production was the weakest since early 2016 and both leading economic indicators and business confidence were notably soft. Major emerging-market economies struggled, with near-recession conditions (or worse) in Argentina, Brazil, Russia, South Africa, Turkey and - new to the sick ward - Mexico. Reports from China were mixed: second-quarter GDP growth came in at +6.2%, a slight deceleration from the prior reading (+6.4%), while more timely releases featured purchasing managers indices and commercial GDP proxies stabilizing above turn-of-the-year levels.

Global central banks began in earnest to loosen monetary policy, undoing some of the tentative tightening that began in late 2017. The U.S. Federal Reserve cut short-term interest rates twice by a cumulative 0.50%; the European Central Bank lowered rates and announced a resumption of asset purchases (quantitative easing); the People's Bank of China lowered bank reserve requirements and made technical policy changes that had the effect of a rate cut; numerous emerging-market central banks joined the lower-rates bandwagon. These moves mark a sea-change from a year ago, when the Fed's intent was to raise rates multiple times during 2019-2020, and most investors thought it was only a matter of time before other central banks followed suit.

While headline U.S. stock indices traded in a narrow range, there was a notable internal 'rotation' away from growth-oriented and large-company stocks in favor of value-oriented and small-company shares. Between mid-to-late August and mid-September, an exchange-traded fund tracking large-cap value stocks outperformed its growth counterpart by more than 350 basis points; in the small-cap arena, the comparable value-outperformance was 500 basis points. In roughly the same timeframe, small-cap stocks overall bested large caps by more than 450 basis points.

Noteworthy political and geo-political developments added drama. While the late-breaking impeachment-inquiry announcement was surely the most noteworthy, Boris Johnson's remarkably ham-handed efforts to navigate the Brexit endgame had Europeans on the edge of their seats. And though disruption of energy markets was limited, the mid-September attack on major Saudi oil-production facilities, which Western governments attributed to Iran, marked an eyebrow-raising escalation of tensions in the Persian Gulf region.

Profits reported by companies that comprise the S&P 500 Index, mostly covering the April-June period, eked out a gain of less than half a percent compared to the year-ago period. Wall Street analysts expect earnings growth of less than 3% for the third quarter and now see the calendar-year figure coming in around +4%, compared to nearly +10% in January - the largest paring back of earnings expectations since 2016.

What's Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1. Dividend Income (for three months this is the annual yield divided by four)
2. +/- Change in Earnings per Share* (average for S&P 500 companies)
3. +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

* based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to produce the +1.7% S&P 500 total return?

Our read: We don't like to see the earnings-growth measure fall to zero. Though lower bond yields support increased valuation, a sustainable market advance will eventually require a resumption of profit growth.

Outlook

The present investment environment is characterized by five undergirding facts: 1) Sluggish global growth, with weakness concentrated in the manufacturing/traded-goods sector; 2) heightened political/policy uncertainty, especially but not limited to volatile trade relations between the U.S. and China; 3) extremely low global bond yields; 4) increasingly aggressive/geographically expanding central-bank policy accommodation; and 5) a historically strong U.S. dollar. The first two and final items are unambiguous headwinds for (U.S. based) stock investors; the third and fourth are (mostly) salutary. We'd call the current situation a glass half empty (at best); but what about the future? Our comments below focus on the economic-growth and political/policy arenas.

Much has been made of the recent 'inversion' of the U.S. Treasury yield curve; i.e., long-term rates (e.g., 10-year Treasury Notes) falling below shorter-term ones (e.g., three-month T-bills) - historically a useful recession predictor. Some economists, however, question this signal's validity in the current environment. They cite, among other factors, unprecedented market intervention by central banks since the financial crisis - directly via long-term asset purchases (quantitative easing) and indirectly via regulatory changes that affect the portfolio preferences of commercial banks and insurance companies - as well as declining and, more important, less volatile inflation. Taking all this into account, in early September, Capital Economics estimated the likelihood of a near-term recession at below 20% (though this is admittedly above normal); and by late September the probability had receded - a conclusion supported by the late-period back-up in yields and outperformance of more economy-sensitive small-cap and value-oriented stocks (though perhaps undermined by early-October developments).

Moreover, although the global economy is clearly laboring, numerous signs indicate growth has been slowing rather than collapsing. For nearly every dour figure from the manufacturing/ traded-goods sectors there seems to be an offsetting upbeat datapoint from the consumer, real-estate or service sectors. In fact, economic 'diffusion' indices (which measure whether the flow of economic data is deteriorating or improving with respect to market expectations) recently moved into positive territory for the first time this year.

Also worth noting is that current weakness is partly a delayed response to tightening policies (both monetary and fiscal) during 2018. As noted, global monetary policy has turned strongly accommodative in recent months (though the expected boost to growth will come with a lag). Meanwhile, there is ample room (though perhaps less political will) for fiscal stimulus, particularly in northern Europe, but also in China; the Trump administration, too, has been rumored to be considering new tax cuts.

All of this said, the broadening manufacturing downturn surely warrants ongoing scrutiny. As we write, the most recent manufacturing-sector PMI data indicate the global manufacturing sector has contracted for five-straight months; and, according to a tally by the Financial Times, August/September industrial output was lower than a year ago in all 36 advanced economies. Especially concerning was the surprisingly weak service-sector PMI report of October 3^rd, which was the lowest reading in over three years. Renewed stock market volatility sparked by the release of these data is surely a yellow flag.

The status of global trade relations remains the most important policy wildcard - one that may be even less predictable due to the rapidly developing impeachment-inquiry process. On one hand, one might expect the current de-escalation phase to extend through the election season; after all, the last thing an embattled incumbent wants is a faltering economy. Alternatively, Mr. Trump could seek to distract attention from impeachment headlines, and energize his base, by playing hardball with the Chinese (and Europeans, Canadians, Japanese, Mexicans…). Recent suggestions the dispute with China could widen to cover financial-market listings and investment flows were not encouraging in this regard. We'd say this one is almost impossible to handicap; we'll be watching developments carefully - along with everyone else.

A further implication of the impeachment process is that it may, as it ebbs and flows, meaningfully affect market perceptions of the likelihood of a Democrat - possibly a progressive Democrat like Senator Warren - occupying the White House in 2021 (with probable coattail effects elsewhere). Many elements of the likely Democratic platform - e.g., new/higher taxes on income, realized gains and perhaps even accumulated wealth; taxes on financial transactions; universal and/or single-payer healthcare reform - are likely to be perceived, at least initially, as investor-unfriendly. Accordingly, shifting views regarding their likelihood of coming to pass could create substantial market volatility. In any case, the specter of impeachment would seem to introduce a new source of potential volatility to the President's words and actions, which were already rather... unpredictable.

While we are encouraged by investors' recent embrace of value-oriented and small-company stocks, we are reluctant to label it a trend. The rotation appears to have been a reaction to improving economic data and bottoming bond yields, which prompted certain investors to close short positions in small-cap and value shares whose underperformance was seen coming to an end (at least temporarily). As we write, the rotation seems to have been put on hold, with recent data auguring persistent economic weakness (and lower yields). Were this trade to resume, however, it would surely have far to run: institutional investors have spent much of the past decade moving incrementally away from small/value in favor of large/growth, resulting in a historically large valuation discrepancy between the styles. We have previously drawn attention to a similarly large valuation advantage with respect to non-U.S. stocks vis a vis their domestic counterparts. Long-term performance is likely to be enhanced by maintaining (or adding) portfolio exposure to these undervalued asset categories within a balanced structure emphasizing prudent risk control.

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